Central banking redux ahead

In its latest monetary policy stance, the Reserve Bank of India has pitched for dearer cost of funds read interest rates, yet again, as per its declared policy intention of stemming the growing inflationary spiral of steadily rising prices. Meanwhile, in the main mature markets, interest rates remain at record lows, in the continuing bid to boost output, employment and overall growth. A recent working paper at the Bank for International Settlements, BIS, the central bankers' bank, is on the seeming state of flux and the changing role of central banks. The paper opines that following the financial crisis abroad, the role and nature of central banking is likely to significantly change.

The paper adumbrates that in the aftermath of the 2007-10 crisis, there's likely to be more intrusive financial regulation, greater government involvement in policy formulation, and less reliance on market mechanisms to correct glitches and shortcomings. Also, there's likely to be greater policy interaction between the treasury and the monetary authority, read the finance ministry and the central bank. The paper is cautiously optimistic that instead of central bank subservience, there would be a more even-handed partnership, even as the range and scale of interaction with government is stepped-up globally. The study calls for policy intervention in banking and finance that is less draconian, with the emphasis less on direct quantitative controls and more on the pricing mechanism, complete with graduated macroprudential norms.

The paper elaborates on how the Basel (the Swiss city in which BIS is based) norms on capital adequacy ratios for commercial banks were worked out. Back in the 1980s, the US Congress wanted to establish a stronger capital base for US banks, following a series of bank failures in 1982. But the banks complained that they would lose business to foreign–especially Japanese–banks. It was then that the Head of the Federal Reserve, Paul Volcker, was mandated to go to Basel to lobby the Basel Committee on Banking Supervision to chalk out an international standard for bank capital.

The end result was the Basel Accord of 1988, after much negotiation, which required a minimum of 4% of risk-weighted assets for Tier I capital, and of 8% for Tier I plus Tier 2 capital. The ratio was not based on much empirical analysis or on theoretical understanding, but was simply decided on a pragmatic basis as a numerical target that commercial banks could be reasonably expected to reach in the foreseeable future, after a period of transition, of course. But there was a catch. And it could well have led to the latest crisis. The point is that Basel I norms were crudely defined, and specifically incentivized banks to securitise those loans read assets whose regulatory requirement were seen as 'excessive.' This led to further negotiations, and Basel II set of norms, under which the risk weightings were to be based on the risk assessments of banks via internal ratings. Note that in altering the risk weightings, Basel II made no significant changes to the definition or indeed the requirement of capital.

Fast-forward to the here and now, and the US investment houses (labelled broker-dealers) as also the European banks were subject to Basel II norms, but not to a simple leverage ratio. So there was perverse incentive to jack-up holdings of mortgage-backed securities, including of sub-prime mortgages or those with dicey payment record, which anyway carried minuscule risk weighting as they rated mostly AAA at the time. After all the underlying assets, houses, were rising in value for years in the run-up to the financial crisis. Note also that in the US, where the financial crisis originated, home loans are mostly of the non-recourse type, where should one vacate the house and hand over the keys to the bank, there are no other obligations on the part of the borrower. It is perverse incentive to default on mortgage payment should house prices fall. Also, US commercial banks were subject to a simple leverage ratio, but not at the time to Basel II requirements. So they hiked their investment in structured products read mortgage-backed securities as well. The paper mentions this as background analysis.